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FRM Part II · FRM Exam Part II · Range of Practices and Issues in Economic Capital Frameworks

During validation of an economic capital model, a bank finds that its credit risk and market risk capital are aggregated by simply summing the stand-alone figures. The validator argues this is conservative but flawed as a model. Which is the most accurate statement of the main issue?

Simple summation implicitly assumes perfect dependence between risk types, ignoring diversification. It therefore overstates total economic capital relative to a model that captures imperfect dependence, and it can distort capital allocation and risk-adjusted performance measurement across business lines.

  1. ASumming assumes perfect dependence across risk types, ignoring diversification and so overstating capital, which can distort risk-adjusted performance comparisonsCorrect
  2. BSumming understates capital because correlations between risk types are always negative
  3. CSumming is the only approach acceptable to supervisors, so no issue exists
  4. DSumming causes capital to be undefined when the risk types use different time horizons

Explanation

Simple addition implicitly assumes perfect correlation of tail losses, ignoring diversification benefits. This overstates total capital relative to a model reflecting imperfect dependence, and can misstate business-line performance. It is not undefined, and other aggregation methods are used in practice.

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